The voting part of the equation is tempered by fear and greed. It is largely emotional, although investors like to think of themselves as rational players. That emotion is driven by views of the future. If you can be confident of large and growing returns, you are less likely to be swayed by the erratic movements of a stock. But as confidence wanes? Well, that is the stuff that bear markets are made of.

Because at the end of the day, what the market weighs is earnings and the ability of a company to reliably produce them. This week we look at what earnings are likely to be over the next year and see if we can discern what that suggests for the markets. We also take a look at the energy markets, the possibility of a further drop in the price of oil, and muse on what a sane energy policy for the world would look like. There is a lot to cover, but it should make for an interesting letter.

Earnings and Mr. Bear

A theme in this letter for many years has been that over time markets of all descriptions revert to the mean. The classic definition of mean reversion is "the behavior of a variable in which the values for that variable move towards the long-run average value for that variable." Prices, indexes, and all types of economic variables tend to fluctuate around their long-term averages.

Profits as a percentage of nominal GDP is one of the more significant mean reversion examples. Last year we saw pre-tax profits as a percentage of nominal GDP climb to a 55-year high of 14%, which is really rather astounding. Why? Because over time, profits track nominal GDP. In the post-World War II era, nominal GDP growth has averaged 7.1%, while profit growth has averaged 7.4%. Profits over the long term as a percentage of GDP have not changed significantly for generations. Or put another way, profit growth has matched GDP growth. We will examine later what might happen if profits reverted to their long-term average (think ugly).

Now, in the short term, the difference between corporate profits and nominal GDP can vary wildly. But in the fullness of time, economic pressures will work to bring corporate profits back to the mean. This can come in the form of higher or lower wages, changes in productivity, higher or lower taxes, recessions, or growth booms. All of these and more affect corporate profits.

Let me give you one more way to look at it. If the economy is growing at 7% (nominal), then corporate profits cannot continue to grow for more than a few years at 15%. If that growth trend continued, then at some point in the future the entire GDP would consist of corporate profits, as each year the percentage of corporate profits in the GDP would increase. Since trees cannot grow to the sky, nor can corporate profits become larger than the economy, and so logic dictates that there will be an adjustment in the future. And we are beginning to see that logic play out. Let's look at a few numbers.

Trailing as-reported 12-month corporate profits on the S&P 500 peaked in the second quarter of 2007 at $84.95. In March of 2007, S&P forecast 2008 earnings would be $92. Then the economy began to run into trouble and S&P began to drop their 2008 forecasts, as the table below shows. (By the way, this is not to pick on S&P. Nearly every major forecast had similarly optimistic views.)

Earnings Before Bad Stuff

But the analysts at S&P must expect a lot of Bad Stuff in 2009, because they project a difference of almost 45% in 2009. Remember that they project real earnings to be $67.66 in 2009? Well, they project operating earnings to be a whopping $108.60. That will be a growth in earnings of almost 25% in 2009.

Before we get into whether such earnings growth is likely, think about an environment where company after company keeps reporting large write-downs every quarter. Of course, they will tell you it is just this once, so don't sell us - now is a buying opportunity. Long-time readers know that I have written on several occasions about how continuing earnings disappointments are what create a bear market. Typically it takes at least three to really get the attention of analysts and investors, who begin to lower their projections for both profits and price targets.

How Ugly Can it Get?

David Rosenberg, the North American Economist at Merrill Lynch, is one of my favorite analysts. He is a mainstream economist who is most definitely not a cheerleader. He can be quite bullish as times, and when he thinks the times call for it, he can be rather bearish. As we will see below, he is quite bearish of late. I am going to quote from his opening remarks in a commentary dated July 25, where he is changing his forecast. Remove sharp objects from your nearby vicinity.

"Forecast addendum: Adjusting to the new reality

"Just like consumers, who are insulating their windows and making fewer trips to the malls, we are adjusting our economic forecast to the new high-oil price reality not to mention the latest round of trauma in the mortgage markets. Though fiscal stimulus [rebate checks] will provide a lingering boost to 3Q we expect GDP to plummet 2.5% in 4Q and see a similar decline in 1Q.